Stephenson Real Estate Company was founded 25 years ago by the current CEO, Robe
ID: 2752280 • Letter: S
Question
Stephenson Real Estate Company was founded 25 years ago by the current CEO, Robert Stephenson. The company purchases real estate, including land and buildings, and rents the property to tenants. The company has shown a profit every year for the past 1 8 years, and the shareholders are satisfied with the company's management. Prior to founding Stephenson Real Estate, Robert was the founder and CEO of a failed alpaca farming operation. The resulting bankruptcy made him extremely averse to debt financing. As a result, the company is entirely equity financed, with 1 2 million shares of common stock outstanding. The stock currently trades at $48.50 per share.
Stephenson is evaluating a plan to purchase a huge tract of land in the southeastern United States for $45 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Stephenson's annual pretax earnings by $1 1 million in perpetuity. Kim Weyand, the company's new CFO, has been put in charge of the project. Kim has determined that the company's current cost of capital is 1 1 .5 percent. She feels that the company would be more valuable if it included debt in its capital structure, so she is evaluating whether the company should issue debt to entirely finance the project. Based on some conversations with investment banks, she thinks that the company can issue bonds at par value with a coupon rate of 7 percent. Based on her analysis, she also believes that a capital structure in the range of 70 percent equity30 percent debt would be optimal. If the company goes beyond 30 percent debt, its bonds would carry a lower rating and a much higher coupon because the possibility of financial distress and the associated costs would rise sharply. Stephenson has a 40 percent corporate tax rate (state and federal).
STEPHENSON REAL ESTATE RECAPITALIZATION
Market value balance sheet before the land purchase is:
Market value balance sheet
Assets
$582,000,000
Equity
$582,000,000
Total assets
$582,000,000
Debt & Equity
$582,000,000
Market value balance sheet after purchase of land:
Note, to calculate the NPV of the project, you must perform a calculation to determine the earnings they will receive from this purchase
Market value balance sheet
Old assets
$582,000,000
NPV of project
enter value
Equity
enter value
Total assets
Sum total
Debt & Equity
Sum total
After calculating the new market balance sheet with the purchase of land using equity, you will then need to calculate the change in stock value and how much stock would need to be issues to purchase the land.
If Stephenson wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? Explain.
Review Stephenson's market value balance sheet before it announces the purchase.
Suppose Stephenson decides to issue equity to finance the purchase.
What is the net present value of the project?
Review Stephenson's market value balance sheet after it announces that the firm will finance the purchase using equity. What would be the new price per share of the firm's stock? How many shares will Stephenson need to issue to finance the purchase?
Review Stephenson's market value balance sheet after the equity issue but before the purchase has been made. How many shares of common stock does Stephenson have outstanding? What is the price per share of the firm's stock?
Review Stephenson's market value balance sheet after the purchase has been made.
Suppose Stephenson decides to issue debt to finance the purchase.
What will the market value of the Stephenson company be if the purchase is financed with debt?
Review Stephenson's market value balance sheet after both the debt issue and the land purchase. What is the price per share of the firm's stock?
Which method of financing maximizes the per-share stock price of Stephenson's equity?
Market value balance sheet
Assets
$582,000,000
Equity
$582,000,000
Total assets
$582,000,000
Debt & Equity
$582,000,000
Explanation / Answer
a. If Stephenson wishes to maximize the overall value of the firm, it should use debt to finance the $100 million purchase. Since interest payments are tax deductible, debt in the firm’s capital structure will decrease the firm’s taxable income, creating a tax shield that will increase the overall value of the firm.
Stephenson’s market-value balance sheet before the announcement of the land purchase is:
c. i. As a result of the purchase, the firm’s pre-tax earnings will increase by $25 million per year in perpetuity. These earnings are taxed at a rate of 40%. Therefore, after taxes, the purchase increases the annual expected earnings of the firm by $15 million {($25 million)(1 - 0.40)}.
Since Stephenson is an all-equity firm, the appropriate discount rate is the firm’s unlevered cost of equity capital (r0), which is 12.5%.
NPV(Purchase) = - $100,000,000 + {($25,000,000)(1 – 0.40) / 0.125}
= - $100,000,000 + ($15 million / 0.125)
= $20,000,000
Therefore, the net present value of the land purchase is $20 million.
ii. After the announcement, the value of Stephenson will increase by $20 million, the net present value of the purchase. Under the efficient-market hypothesis, the market value of the firm’s equity will immediately rise to reflect the NPV of the project.
Therefore, the market value of Stephenson’s equity will be $507.5 million (= $487.5 million + $20 million) after the firm’s announcement.
Stephenson s market-value balance sheet after the announcement is:
Since the market value of the firm’s equity is $507.5 million and the firm has 15 million shares of common stock outstanding, Stephenson’s stock price after the announcement will be $33.83 per share (= $507.5 million / 15 million shares).
Stephenson’s stock price after the announcement is $33.83 per share.
Since Stephenson must raise $100 million to finance the purchase and the firm’s stock is worth $33.83 per share, Stephenson must issue 2,955,956 shares ( = $100 million / $33.83 per share) in order to finance the purchase.
Stephenson must issue 2,955,956 shares in order to finance the initial outlay for the purchase.
iii. Stephenson will receive $100 million (= 2,955,956 shares * $33.83 per share) in cash as a result of the equity issue. This will increase the firm’s assets and equity by $100 million.
Stephenson’s market-value balance sheet after the equity issue is:
Since Stephenson issued 2,955,956 shares in order to finance the purchase, the firm now has 17,955,956 (= 15,000,000 + 2,955,956) shares outstanding.
Stephenson will have 17,955,956 shares of common stock outstanding after the equity issue.
Since the market value of the firm’s equity is $607.5 million and the firm has 17,955,956 shares of common stock outstanding, Stephenson’s stock price after the equity issue will be $33.83 per share (= $607.5 million / 17,955,956 million shares).
Stephenson’s stock price after the equity issue remains at $33.83 per share.
iv. The project will generate $25 million of additional annual pre-tax earnings forever. These earnings will be taxed at a rate of 40%. Therefore, after taxes, the project increases the annual earnings of the firm by $15 million {=($25 million)(1 - 0.40)}. The present value of these cash flows is equal to a perpetuity making annual payments of $15 million, discounted at 12.5%.
PVPROJECT = $15 million / 0.125
= $120 million
Stephenson’s market-value balance sheet after the purchase has been made is:
d. i. Modigliani-Miller Proposition I states that in a world with corporate taxes:
VL = VU + TCB
where VL = the value of a levered firm
VU = the value of an unlevered firm
TC = the corporate tax rate
B = the value of debt in a firm’s capital structure
As was shown in part c, Stephenson will be worth $607.5 million if it finances the purchase with equity. If it were to finance the initial outlay of the project with debt, the firm would have $100 million worth of 8% debt outstanding.
Thus: VU = $607.5 million
TC = 0.40
B = $100 million
If Stephenson chooses to finance the purchase using debt, the firm’s market value will be:
VL = VU + TCB
= $607.5 million + (0.40)($100 million)
= $647.5 million
Therefore, Stephenson will be worth $647.5 million if it chooses to finance the purchase with debt.
ii. After the announcement, the value of Stephenson will immediately rise by the PV of the project. Since the market value of the firm’s debt is $100 million and the value of the firm is $647.5 million, the market value of Stephenson’s equity must be $547.5 million (= $647.5 million - $100 million).
Stephenson’s market-value balance sheet after the debt issue is:
Since the market value of the Stephenson’s equity is $547.5 million and the firm has 15 million shares of common stock outstanding, Stephenson’s stock price after the debt issue will be $36.50 per share (= $547.5 million / 15 million shares).
Stephenson’s stock price after the debt issue will be $36.50 per share.
e. If Stephenson uses equity in order to finance the project, the firm’s stock price will remain at $33.83 per share. If the firm uses debt in order to finance the project, the firm’s stock price will rise to $36.50 per share.
Therefore, debt financing maximizes the per share stock price of a firm’s equity.
Stephenson Real Estate Assets = $ 487,500,000 Debt = $ - Equity = $ 487,500,000 Total Assets = $ 487,500,000 Total D + E = $ 487,500,000Related Questions
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